Inspiration from physics for thinking about economics, finance and social systems

Friday, September 30, 2011

The Fetish of Rationality

I'm currently reading Jonathan Aldred's book The Skeptical Economist. It's a brilliant exploration of how economic theory is run through at every level with hidden value judgments which often go a long way to determining its character. For example, the theory generally assumes that more choice always has to be better. This follows more or less automatically from the view that people are rational "utility maximizers" (a phrase that should really be banned for ugliness alone). After all, more available choices can only give a "consumer" the ability to meet their desires more effectively, and can never have negative consequences. Add extra choices and the consumer can always simply ignore them.

As Aldred points out, however, this just isn't how people work. One of the problems is that more choice means more thinking and struggling to decide what to do. As a result, adding more options often has the effect of inhibiting people from choosing anything. In one study he cites, doctors were presented with the case history of a man suffering from osteoarthritis and asked if they would A. refer him to a specialist or B. prescribe a new experimental medicine. Other doctors were presented with the same choice, except they could choose between two experimental medicines. Doctors in the second group made twice as many referrals to a specialist, apparently shying away from the psychological burden of having to deal with the extra choice between medicines.

I'm sure everyone can think of similar examples from their own lives in which too much choice becomes annihilating. Several years ago my wife and I were traveling in Nevada and stopped in for an ice cream at a place offering 200+ flavours and a variety of extra toppings, etc. There were an astronomical number of potential combinations. After thinking for ten minutes, and letting lots of people pass by us in the line, I finally just ordered a mint chocolate chip cone -- to end the suffering, as it were. My wife decided it was all too overwhelming and in the end didn't want anything! If there had only been vanilla and chocolate we'd have ordered in 5 seconds and been very happy with the result.

In discussing this problem of choice, Aldred refers to a beautiful paper I read a few years ago by economist John Conlisk entitled Why Bounded Rationality? The paper gives many reasons why economic theory would be greatly improved if it modeled individuals as having finite rather than infinite mental capacities. But one of the things he considers is a paradoxical contradiction at the very heart of the notion of rational behaviour. A rational person facing any problem will work out the optimal way to solve that problem. However, there are costs associated with deliberation and calculation. The optimal solution to the ice cream choice problem isn't to stand in the shop for 6 years while calculating how to maximize expected utility over all the possible choices. Faced with a difficult problem, therefore, a rational person first has to solve another problem -- for how long should I deliberate before it becomes advantageous to just take a guess?

This is a preliminary problem -- call is P1 -- which has to be solved before the real deliberation over the choice can begin. But, Conlisk pointed out, P1 is itself a difficult problem and a rational individual doesn't want to waste lots of resources thinking about that one too long either. Hence, before working on P1, the rational person first has to decide what is the optimal amount of time to spend on solving P1. This is another problem P2, which is also hard. Of course, it never ends. Take rationality to it's logical conclusion and it ends up destroying itself -- it's simply an inconsistent idea.

Anyone who is not an economist might be quite amazed by Conlisk's paper. It's a great read, but it will dawn on the reader that in a sane world it simply wouldn't be necessary. It's arguing for the obvious and is only required because economic theory has made such a fetish of rationality. The assumption of rationality may in some cases have made it possible to prove theorems by turning the consideration of human behaviour into a mathematical problem. But it has tied the hands of economic theorists in a thousand ways.

Mircea Eliade, in his 1957 work, The Sacred and the Profane: The Nature of Religion, had his doubts: "In short, the majority of men 'without religion' still hold to pseudo religions and degenerated mythologies. There is nothing surprising in this, for, as we saw, profane man is the descendant of homo religiosus and he cannot wipe out his own history – that is, the behavior of his religious ancestors which has made him what he is today. This is all the more true because a great part of his existence is fed by impulses that come to him from the depths of his being, from the zone that has been called the 'unconscious.' A purely rational man is an abstraction; he is never found in real life. Every human being is made up at once of his conscious activity and his irrational experiences." (Chp. 4, § "Sacred and Profane in the Modern World.”).

F.A. Hayek, in The Constitution of Liberty, concurred: “All rational thought moves within a non-rational framework of beliefs and institutions” (Chp. 12).

Good overall points, IMHO. However, I think critiques like this about rationality in economics miss the point. The rationality assumed in economics is concerned with general trends; generally people pursue pleasure, not pain (according to their own utility functions), they prefer more money to less (an expanded budget constraint leaves them on a higher indifference curve, thus better off), they have consistent preferences (when they're in the mood for chocolate, they're not going to choose vanilla). Correspondingly, firms have the goal of profit maximization - they produce products that somebody will want to buy or they go out of business. Taking the rationality assumption to its "umpteenth" iteration is really quite irrational in itself. A consumer knows that spending 6 years to calculate the mathematically optimal choice of ice-cream is irrational. An economist accordingly knows the same thing. And although assumptions are required for modelling economic scenarios (micro or macro), I seriously doubt that any serious economist would make assumptions that infer such irrationality. :).

@Relja - You learned your economic theories well, but the assumptions underlying them are not a foregone conclusion. Consider pleasure and pain in more detail (from the paper The Dignity of Humanity, on Scribd at http://www.scribd.com/doc/22328155/The-Dignity-of-Humanity), which wraps back to the discussion of rationality:

"Utilitarianism itself proposed a very simplistic outlook on decision making. If human endeavor was indeed so simple as to break down between pleasure an pain, we could indeed appreciate the possibilities for this decision-making calculus. But human endeavor is far more complicated. Mill dismissed human emotions such as sympathy, love or fear as simply "collateral associations" to pleasure and pain. Yet we implicitly understand a richer meaning behind these emotions and while there is some association maintained with pleasure and pain, sorting the human experience into two tidy categories rings hollow; any such attempt demeans human experience. The very fact that we have developed an intricate typology of human emotions proves to be no accident of history. This intricacy, in fact, points to the complexity of what it means to be human. The complexity weighs in against any binary usefulness that Utilitarians claim for pleasure and pain...

"Furthermore, human emotions such as "hope" and "fear" do not readily fall into the categories of pleasure and pain, unless we rely on theoretical circumnavigation to achieve our ends and if we must, then the exercise quickly becomes futile. Puzzling indeed is reading Mill's understanding of the importance of hopes and fears in Utilitarianism and in On Liberty: "Every function superadded to those already exercised by the government," Mill writes in the latter essay, "causes its influence over hopes and fears to be more widely diffused and converts, more and more, the active and ambitious part of the public into hangers-on of the government...." Mill treads upon the terrain of hopes and fears, and yet fails to recognize the importance of this hallowed ground when he defends Utilitarianism...

"Since Utilitarianism diminishes the range of human emotions – such as "passion" or "empathy," "anger" or "love" – as being merely "collateral associations," the fullness of human experience is not brought to bear on decision making. And rest assured, without these human emotions "irrationally" affecting our decision making, we humans would be far poorer for the experience. In fact, there would be little to distinguish us from automatons. As Laurence Sterne observed in Tristram Shandy: "Need I be told, dear Yorick, as I was by you, in Le Fever's funeral sermon, That so soft and gentle a creature, born to love, to mercy, and kindness, as man is, was not shaped for this?––But why did you not add, Yorick,––if not by NATURE––that he is so by NECESSITY?" (Vol. VI, Chp. 32)."

"The theory of rational behavior is usually presented as a study of the principles upon which a rational man would act. This Rational Man is unlike you or me in that he makes no errors in arithmetic or logic in attempting to achieve his clearly defined objectives. He is like you and me, on the other hand, in that he is neither omnipotent nor omniscient. He must make decisions, such as the selection of a portfolio, in the face of uncertainty. Since his information is limited, he may take less than perfect actions. Since his powers are limited, his achievements may fall short of the best conceivable. Every action, however, is perfectly thought out; every risk is perfectly calculated.

The Rational Man, like the unicorn, does not exist. An attempt to see general principles by which he would act, however, can be suggestive for our own actions.

Another interpretation can be given to the theory of rational behavior. Rather than visualizing a Rational Man we can visualize a Perfect Computing Machine with unlimited speed and capacity. This computing machine instantly processes all available information to determine a portfolio for us. The study of rational behavior may be viewed as an enquiry into the principles by which we would have this Perfect Computing Machine proceed.

The Perfect Computing Machine, like the unicorn and the rational man, does not exist. Limitations of speed and storage will always constitute a practical as well as theoretical restriction. Reflection on what we would ask of such a machine, however, can provide a perspective on what we should ask of our real machines.

The theory of rational behavior is not a substitute for human judgement. There is no theory by which we could dispense with human beings if we had a sufficiently large and fast computer. The study of rational behavior has produced only general principles to be kept in mind as guides. Even the significance of some of these principles is subject to controversy. The value of the study of rational behavior is that it supplies us with a new viewpoint on problems of criteria - a viewpoint to be added to common sense to serve as a basis of good judgment."Harry Markowitz (1959), p. 206-7. http://cowles.econ.yale.edu/P/cm/m16/m16-10.pdf

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